Key Takeaways

  • An S corp is a pass-through entity that avoids double taxation by allowing income, losses, and other tax items to flow directly to shareholders.
  • Shareholders report business income on their personal tax returns and are taxed at individual rates.
  • S corps offer self-employment tax advantages, especially for owner-employees who pay themselves a reasonable salary.
  • There are strict IRS rules regarding distributions, shareholder limits, and reasonable compensation.
  • Loss deductions are limited by each shareholder’s basis, at-risk amount, and passive activity rules.
  • While S corps avoid corporate taxes, compliance requirements and ownership restrictions can be burdensome.
  • Choosing between an S corp and other entity types requires evaluating taxation, ownership goals, and administrative needs.

S Corp Pass Through

An S corp pass through is a special business entity whose earnings, losses, deductions, and credits pass through to its shareholders' individual tax returns.

How S Corp Pass-Through Taxation Works

An S corporation is structured to avoid double taxation by acting as a pass-through entity. This means that instead of the corporation paying federal income taxes, the business income, deductions, credits, and losses "pass through" to the shareholders. Each shareholder then reports their share on their personal income tax return using Schedule E, and pays taxes at their individual income tax rate.

This setup contrasts with C corporations, which face double taxation—once at the corporate level and again when dividends are paid to shareholders. By contrast, S corps distribute income only once—at the shareholder level.

To maintain pass-through status, S corps must meet IRS requirements, such as having no more than 100 shareholders and offering only one class of stock.

What Is an S Corporation (S Corp)?

  • An S corporation protects against double taxation, while offering the benefits of limited liability.
  • For federal tax purposes, an S corporation is considered as a pass-through entity through a special status granted by the Internal Revenue Service (IRS).
  • An S corporation is set up by filing Articles of Incorporation, and it has shareholders and directors to run the company just like in the case of a C corporation.
  • Bank accounts and other personal assets of S corp shareholders cannot be seized to settle the business liabilities of the corporation.
  • An S corporation passes through its profits and losses to its shareholders just like a sole proprietorship business or a partnership firm. Shareholders pay income taxes on their shares of income at individual tax rates.
  • Unlike a regular company, where tax is first levied at the corporate level and then again at the individual level, an S corp saves you from double taxation.

S Corp Advantages

  • The S corporation status is especially beneficial at the time of ownership transfer or when you decide to discontinue the business.
  • Except in case of express personal guarantee, S corporation shareholders cannot be held responsible for their company's debts and liabilities.
  • Unlike in partnership and sole proprietorship businesses, creditors of S corporations cannot ask to settle their debts from the personal property of shareholders.
  • S corporation earnings are not subject to corporate income tax.
  • S corporation shareholders can set off business losses against their personal taxable income. This can be greatly helpful during the initial years of a new business, when startup costs are higher.
  • S corporation shareholders can work as employees and draw wages from the company while continuing to receive tax-free distributions on their investment.
  • Employee shareholders can save on self-employment taxes while the company can claim deductions for the wages paid to them.
  • Transfer of ownership in an S corporation is simple and without adverse tax impacts. In the case of standard corporations and partnership firms, transferring an interest of more than 50 percent can result in the termination of business.
  • There are no complicated accounting procedures involved (like adjusting the property basis) during ownership transfer of an S corporation.
  • S corporations that do not have inventory can follow a cash basis of accounting, which is far easier than the accrual method.
  • Forming an S corporation gives credibility to your business.

Tax Savings Through Reasonable Compensation

One key tax advantage of an S corp is the ability to reduce self-employment taxes. Unlike sole proprietors or partners, S corp shareholders who work for the business can pay themselves a "reasonable salary" subject to employment taxes, and then take additional income as distributions, which are not subject to self-employment tax.

This dual compensation strategy can lead to significant savings, but the IRS monitors it closely. Paying too little in salary to avoid employment taxes can trigger penalties. A reasonable salary should be based on industry standards, experience, duties, and the geographic region.

S Corp Disadvantages

  • Forming and operating an S corporation involves certain formalities and expenses, like filing Articles of Incorporation, finding a registered agent, submitting returns, and paying appropriate fees.
  • Several states impose franchise taxes and annual report fees, which are not applicable to sole proprietorship businesses and partnership firms.
  • Failure to comply with return filing and other obligations can result in the termination of an S corp status.
  • For the purpose of taxation, an S corporation must follow a calendar year except when it has a sound business purpose to follow a fiscal year.
  • An S corporation cannot offer more than one class of shares. Although it can have voting and non-voting shares at the same time, it can't assign different distribution rights to its shareholders. Additionally, it cannot have more than 100 shareholders, and there are also restrictions on foreign ownership.
  • There is a closer scrutiny on payments in order to ensure that they are correctly split between dividends and salaries.
  • Since there is only one type of stock, it's difficult to assign profits and losses to specific shareholders.
  • It's often difficult to maintain the accumulated adjustment account (AAA).
  • Most of the fringe benefits that an S corp employee-shareholder gets are taxable if the receiving shareholder has an ownership of more than two percent.

Distribution Rules and IRS Scrutiny

Distributions from an S corp must be made according to ownership percentages, as S corps are limited to one class of stock. Unequal distributions can jeopardize the company’s S corp status.

The IRS also scrutinizes how income is divided between wages and distributions. To avoid penalties or reclassification, distributions must not be used to avoid payroll taxes improperly. Keeping accurate records and adhering to the IRS's “reasonable compensation” standard is essential.

Basis Limitations and Loss Deductions

S corp shareholders can deduct business losses on their personal returns, but only to the extent of their stock basis and any loans personally made to the corporation. This basis includes the initial investment and any additional capital contributions but excludes loans made by third parties.

Additionally, shareholders are limited by at-risk rules and passive activity loss rules. For example, if a shareholder does not materially participate in the business, losses may be considered passive and not deductible against active income. This limits the tax benefit of early-stage losses in some cases.

How to Start and Form an S Corp

  1. Reserve a name for your business.
  2. Prepare and file Articles of Incorporation.
  3. Issue share certificates to founding shareholders.
  4. Get licenses and certificates applicable to your business.
  5. Apply online or submit Form SS4 for an Employer Identification Number.
  6. Apply for other identification numbers applicable in your area; the most common ones include IDs for unemployment, disability, and payroll taxes.
  7. File Form 2553 within 75 days of forming the company.

Comparing S Corp Pass-Through with Other Structures

When evaluating the S corp pass-through model, it’s important to compare it to other business structures:

  • Sole Proprietorships and Partnerships: Like S corps, these are pass-through entities. However, they don’t provide limited liability protections or the ability to split income between salary and distributions.
  • LLCs: Default taxation is similar to a sole proprietorship or partnership, but LLCs can elect to be taxed as an S corp to access payroll tax advantages.
  • C Corporations: Subject to double taxation, but they allow more flexible profit-sharing, multiple stock classes, and unrestricted shareholder types.

The best structure depends on business goals, growth plans, and tax optimization strategies.

Frequently Asked Questions

  1. What does “pass-through taxation” mean for an S corp?
    It means that the business does not pay federal income tax. Instead, profits and losses are passed through to shareholders, who report them on their personal tax returns.
  2. Can S corp shareholders deduct business losses on their personal returns?
    Yes, but only up to their basis in the company and subject to at-risk and passive activity loss rules.
  3. How does an S corp save on self-employment taxes?
    S corp owners who work in the business can pay themselves a salary (subject to employment taxes) and take additional profits as distributions, which are not subject to self-employment tax.
  4. Are there limits on S corp distributions?
    Yes, distributions must be proportional to share ownership. Unequal distributions can cause the IRS to revoke S corp status.
  5. Can an LLC use S corp pass-through taxation?
    Yes, an LLC can elect to be taxed as an S corp by filing IRS Form 2553, allowing it to take advantage of pass-through taxation and self-employment tax savings.

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